9/24/2009 @ 10:25AM

The Road To 1,200 Is Open

The consensus is so definitive at present that the economy is bound to operate at sub-normal speed next year that it is a worthless hypothesis. Only a handful of economists believe we’ll see 2010′s GDP at a normalized 3.5% annualized growth rate. Include Ben Bernanke in this handful, but his is more a politicized forecast aimed at bolstering consumer confidence and paving the way to raising money market rates.

Bernanke is already months late in blessing the recession’s end. Likewise, the bears on housing need to face reality. Even the Shiller index indicates the housing market bottomed early in summer.

Nobody expects a capital spending pickup, but the continued weakness in the dollar is constructive for our multinationals–specifically technology, pharmaceuticals and industrials. The translation of foreign earning into dollars could add 5% or more to 2010 earnings for multinational corporations. Witness the current strength in properties like
IBM
,
Caterpillar
,
Cisco Systems
and
Dow Chemical
.

The financial press runs story after story with the same theme: a fully priced market in an economic setting that may have a W in its future or at least an L after the second-half fillip of inventory reaccumulation and auto sales recovery. Maybe so, but concluding that the market is fully priced based on this year’s earnings power makes no sense.

Financial markets deal in lead time, ready to discount the next 12 months rather than view economic activity in the rearview mirror. The consensus expected no early end to the recession, horrid loan losses at banks and a seized-up bond market where the window would open only for AAA credits.

All this worry stands wrung out by the buoyancy of fixed-income markets. Even below-investment-grade credits like airlines are tapping the new-issue market.
Delta Air Lines
is about to raise $500 million even with the shadow of bankruptcy ever present if the economy relapses.
American Airlines
just raised $2 billion. Airline stocks have tacked on 50% in the last month and no longer sell as options.
U.S. Airways
was two bucks and change; now it’s a five-dollar bill.

The naysayers’ case remains powerful but conjectural. The consumer accounts for two-thirds of the economy, and right now he’s saving, not spending. Retail sales show no early foot. The remainder of GDP–exports, construction and capital spending–hit bottom, but the benefit to GDP in total will be no more than 1% next year.

Economists like the guy at NYU whose name rhymes with Houdini fall back to the double-dip recession thesis for 2010. This is after predicting the end of the world this past spring. He wasn’t alone. George Soros was profoundly bearish on the developed world’s predicament. Soros preferred China as his investment gambit. Why not?

Beware of punditry. Economists who get things right for half a cycle form advisory businesses, consultancies and moonlight for as much as the market pays. I don’t make a living as a pundit. What I do is put my money where my mouth is. If only I could make a living writing, I’d be deliriously happy.

My point of view is never definitive, but rather a simplistic working hypothesis that can be summed up in less than 25 words: The economy and corporate earnings recover in an environment of low interest rates. Thirteen words.

First is the sharp recovery in emerging economies like China and India. This creates incremental demand for raw materials like steel, copper, iron ore and oil. Much of the market’s rally is focused on raw materials, energy plays and industrials, even railroads.

Metrics on industrial production have begun to improve after drastic cutbacks in assembly-line shifts and employment going back to year’s end. The country is under-inventoried today, particularly the auto sector. Unemployment is peaking and everyone knows it’s sticky for a year or more.

Meanwhile, personal wealth is clawing back at least half of the $12 trillion shrinkage from its peak in late 2007. Home prices turned positive and financial markets–inclusive of equities, corporate debentures and munis–remain in their rally phase.

Even the serious fiscal problems of states and municipalities haven’t stopped capital from pouring into New York state and city paper going out 15 years. Yields were 5.5% a year ago, but now we’re talking 4.5% or below. Corporate debentures of low investment grade with 10-year maturities underwritten six to nine months ago are trading at premiums ranging up to 20 points.

In short, the corporate bond market has given stocks a run for the best asset class this year. More important, the underwriting window is opening up for below-investment-grade paper. Many LBO debentures underwritten in 2006 and 2007 formerly trading at 50 cents on the dollar now tick at 80% par value. Preferred stocks, specifically paper at
Bank of America
and JPMorgan have more than doubled from their March ’09 panic prices.

It’s not written in stone that the consumer can’t come back at least partway from today’s savings mode. I discount the individual savings rate moving up from 5% to previous highs of 8% to 10%. Six months from now, the savings rate could easily contract, particularly if financial markets remain buoyant.

The Federal Reserve Board has little to fear on the inflation front. It can’t control raw materials prices worldwide, but wage inflation is out of the question for years to come. Statistics on hours worked and overtime go nowhere. If oil quotes spike, the Fed will construe this as a tax on consumers. Perhaps Bernanke will take money market rates up to 1% as a token gesture to appease the shadow open market committee crowd. Even 2% wouldn’t upset me.

We remain in an environment of historically low interest rates, both short-term and long-term. The stock market pays up when 10-Year Treasuries remain under 4.5%; we’re at 3.3% now. Valuation metrics suggest a mid-teens price-earnings ratio in this setting. A radical change in Federal Reserve Board policy emphasis is not in the cards for the near term.

Finally, let’s deal with earning power of the S&P 500 Index next year. The consensus has come up to approximately $70 a share, from the low 60s. This estimate assumes moderately higher oil pricing while the financial sector snaps back to approximately 50% of normalized earnings. Loan and investment account write-offs at normal levels is a 2011 event.

Most of the Street’s earnings projections assume flattish technology-sector earnings, which for me is too conservative a reading. I expect a weak dollar will prevail over the next 12 months. This helps earnings of all multinationals, particularly the tech houses and pharmaceuticals.

Most estimates assume no more than 2% GDP growth next year. What if the country recovers to the 3% GDP level? Well, the $70 a share earnings number is blown through. In the game of extrapolation, you’ve got to run 12 months ahead. Projections of $80 a share for 2011 suddenly will pop up, and by simple multiplication–15 times 80–you solve for a 1,200 S&P 500 Index by mid-2010.

Do I hear a voice in the back of the room asking how can I be so definitive? I’m not, but so far my working hypothesis from 900 on bears fruit. There’s loads of smart money still on the sidelines, expecting the W, the L, or at best a U-shaped setting.

Money market funds that pay next to nothing would have imploded after Lehman’s bankruptcy if the government didn’t guarantee them for 12 months. Now the year is up–and trillions remain on the sidelines, earning zilch.

Players who donned crash helmets a year ago need to consider unbuckling. The magic word is resiliency. The valuation structure of the market today at least justifies its present 1,050 reading. At worst, the economy is U-shaped.

Martin T. Sosnoff is chairman and founder of Atalanta/Sosnoff Capital, a private investment management company with more than $9 billion in assets under management. Sosnoff has published two books about his experiences on Wall Street, Humble on Wall Street and Silent Investor, Silent Loser. He was a columnist for many years at Forbes magazine and for three years at The New York Post. Sosnoff owns personally, and Atalanta Sosnoff Capital owns for clients, the following stocks cited in this commentary: IBM, Cisco Systems, Dow Chemical, AMR, Delta Air Lines, U.S. Airways, Bank of America and JPMorgan.